Futures uncertainty increases risk

Many wheat growers in the Southeast who expected to reap big profits from high wheat prices for the 2007-2008 crop ended up disappointed with the price they received for their wheat and disillusioned with the Chicago Board of Trade.

Speaking at the recent 71st annual meeting of the North Carolina Feed Industry Association, Randy Gordon says the CME (Chicago Mercantile Exchange) which now owns the Chicago Board of Trade admits the wheat futures contract is broken.

Gordon, who is vice-president of communications and government affairs for the National Grain and Feed Association, says the same trends are beginning to be seen in corn and many wonder whether soybeans will be next. Gordon says elevator managers and feed mills have lost confidence in futures markets as a risk management tool.

“Down to the farmer level there is little confidence futures prices are a true barometer of what supply and demand conditions are for crop and commodity values,” Gordon says. “Losing the ability to forward contract crops significantly increases what is already a huge risk in farming.”

Gordon explains that investors who manage long-only index funds have invested billions of dollars in both agriculture and energy commodities. All these investors do is continually roll contracts from one delivery date to the next, never planning to take delivery of the commodity.

“At the close of trading in late July, in the soft wheat market in Chicago, there was more than a $2.50 difference in cash prices and futures prices — unprecedented levels. And, the prediction is that this difference or basis price, may go as high as $3 in the wheat market, which is an untenable situation for grain buyers,” Gordon says.

The futures market has created tremendous pressure on the industry to continue to fund margin calls that occur as buyers try to maintain hedge positions. This situation has severely limited forward contracting. Many, if not most lenders, are reluctant to extend contracts longer than 30-60 days, according to Gordon.

Elevator managers have begun asking, and in some cases insisting, that farmers share some of the margin cost, if they want to contract for longer periods of time. Elevators just can't afford to continue to do business as usual.

“Lenders are trying to stick with grain buyers, but it's a tough call on them as well. The risks involved in financing margin requirements, even inventory purchases, have caused some long-term lenders to pull back,” Gordon says.

“At the last meeting of the CME, they publicly admitted for the first time their wheat futures contract is broken. It's been a long time coming, but they now admit the problem that grain buyers have warned was happening over the past couple of years. The CME is now reaching out to the grain industry to try and fix the problem,” Gordon adds.

Red winter wheat is the poster boy for futures market trading with differences in cash and futures prices consistently topping $2. In corn the price differential as of late July was 45 cents and less for soybeans. “The great fear is that corn and beans will go the way of wheat, which would be catastrophic for grain buyers, grain growers and ultimately consumers,” according to Gordon.

Possible solutions the National Grain and Feed Association and other grain industry associations are looking at include:

Encourage, or force takers of deliveries to load out the commodity as specified in the contract.

Add more delivery locations, making delivery a more reasonable option.

Establish a cash settlement contract.

There are a number of possible solutions, but no magic bullet right now, Gordon admits. One of the major stumbling blocks that needs to be fixed, he contends, is that long-term index funds, large retirement funds and other large financial investors in agricultural commodities have very limited reporting responsibilities to the Commodity Futures Trading Commission, which oversees the futures market.

“There are numerous ways for these large investment managers to report the value of their index funds — all perfectly legal. What this says is that we have a broken reporting system, too,” Gordon says.

One option is to get the USDA Commodity Credit Association to provide loan guarantees to lenders who extend credit to elevators and feed mills for hedging commodities. It's a different wrinkle, but indicative of how critical the problem is for grain buyers.

“Farmers would love to contract out into the 2009 crop season to capture some of these high commodity prices. The risk to elevator managers and feed mills is just too great to allow that to happen, unless some dramatic changes are made,” Gordon says.

The biggest fear lenders have in financing grain buying and marketing is that farmers will walk away from contracts and simply not deliver. It's hard from a grower's perspective to contract corn, for example, at $3 a bushel and see prices at over $7 a bushel.

“The best insurance policy against failure to deliver is always to include the National Grain and Feed Association's arbitration rules in contracts with growers. It's not an ironclad guarantee, but a good insurance policy against going to court. Even if cases go to court, most courts have ruled that arbitration agreements are valid and both the grower and buyer tend to come out better,” Gordon says.

The commodity market woes have attracted the attention of the U.S. Congress. An unprecedented bill recently was approved by the House Agriculture Committee. This legislation would require the Commodity Futures Trading Commission issue within 60 days rules on how to prevent excessive speculation on ag and energy futures markets.